Goldman Sees 0.2% China Bond Default Rate as Zombies Kept Alive

  • Global note default rate is 0.8% and U.S. 0.9%: Moody’s says
  • Defaults in China likely to spread for long time: Goldman

China’s effort to prop up struggling firms is keeping its corporate bond default rate a fraction of the global average even after delinquencies spread in the past two years. That’s not a statistic investors are celebrating.

Goldman Sachs Group Inc. estimates that about 0.2 percent of Chinese company bonds are in default, excluding those that were later fully repaid. That pales in comparison to the 0.8 percent of corporate issues that failed in the past 12 months globally and 0.9 percent in the U.S., according to data from Moody’s Investors Service.

While Premier Li Keqiang has pledged to weed out zombie companies, local governments have at times stepped in to help firms struggling to repay debt such as Heilongjiang Longmay Mining Holding Group. Corporate obligations climbed to a record 165 percent of economic output at the end of last year, the latest figures from Bloomberg Intelligence show. AllianceBernstein said earlier this month it will take at least another 12 months before credit risk is properly priced, while BlackRock Inc. said growth fueled by such borrowing is unsustainable.

“Local governments as well as the central government are trying to help corporates to delay defaults,” said Iris Pang, senior economist for greater China at Natixis SA in Hong Kong. “This will continue, otherwise, there would be a series of defaults, which could trigger a credit crunch and later a liquidity crisis.”

A record of at least 10 companies have failed to make local bond payments this year amid the weakest economic growth in a quarter century. That followed 7 in 2015 and 1 in 2014. Goldman estimated in a May 19 report that the total nominal amount of bonds in default is 30 billion yuan. The bank compared that with the 15 trillion yuan of corporate notes outstanding and said “there is a need for more defaults, as they are necessary to improve the credit allocation process.”

Heilongjiang Longmay Mining, a state-owned coal miner, said in November it would use funds from the Heilongjiang provincial government for bond payments in December. Xining Special Steel Co. said in a filing this week that the local government has pledged to offer financing support for its note payments if necessary.

“China’s bond market has only recently opened up,” said Andy Seaman, manager of Stratton Street Capital’s Renminbi Bond Fund. “Once there are more global investors invested China, the local governments may be less willing to bail out the bondholders and the default rates will be similar to global rates.”

China’s leaders are seeking to add fiscal firepower to spur the economy and clear the path for reforms including cutting overcapacity in sectors like coal and steel. The government still has room to borrow more to finance investment, the Ministry of Finance said in a statement on Thursday.

"They are taking on more debt in areas where there is lower growth and return so obviously your default rates are going to increase," Sean Taylor, chief investment officer for Deutsche Asset Management in the Asia-Pacific region, said in Tokyo on Thursday. The government allowing more defaults "will be the greatest sign that China is doing better."

Another key reason for China’s low delinquency rate is that there are no cross default clauses on local notes, according to Ivan Chung, head of Greater China credit research at Moody’s. Many issuers had already reneged on loans before they missed bond payments, he said.

Wang Ying, senior analyst at Fitch Ratings in Shanghai, said the default rate may remain low as the market still has ample liquidity to support refinancing activities and the cost of funding is still relatively low. But an increase in deal cancellations last month was "a warning sign for highly levered issuers in sectors with overcapacity threats,” she said.

While the yield premium over the sovereign on five-year AA- rated notes has declined 28 basis points from this year’s high of 383 basis points on April 26, at least 159 companies have scrapped 180.6 billion yuan of planned local bond sales this quarter.

Moody’s expects China’s onshore public bond defaults to rise to 20 to 25 cases this year, involving 30 billion yuan to 40 billion yuan. Goldman sees a long drawn out cycle of defaults onshore with the impact increasingly felt offshore, analysts Kenneth Ho, Yang Yang and Charles Himmelberg wrote in a May 20 report.

“China’s current debt-fueled growth is unsustainable and the deleveraging process will be lengthy,” Andrew Swan, the Hong Kong-based head of Asian equities at BlackRock, wrote in a May 24 note.

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